Introduction
The Companies Act, 2013. is well known for its provisions on board composition, auditor independence, and related party transactions. However, some equally important provisions have not received the attention they deserve. Sections 185 and 186 fall into this category. While practitioners are generally familiar with each provision in isolation, the danger that arises when they are read together in a group company context is largely overlooked.
This article identifies a specific compliance problem that is quietly affecting thousands of Indian group companies today and suggests a practical way to address it. With the Corporate Laws (Amendment) Bill, 2026 now before Parliament, the timing to course-correct could not be more critical.
The Problem: Step-Loans and the “Indirectly” Trap
What is a Step-Loan?
A step-loan is a back-to-back lending arrangement where Company A lends money to Company B, and Company B then passes those funds on to a director, a director’s relative, or an entity connected to a director. Company A typically believes it has made a lawful inter-corporate loan. What it has actually done is advance an indirect loan to a director, which is absolutely prohibited under Section 185(1).
This structure is common in closely held family group companies where the same promoter-directors sit on the boards of multiple entities. It usually arises not out of deliberate wrongdoing but out of a poor understanding of how these two sections interact.
The Key Word: “Indirectly”
Section 185(1) prohibits a company from, directly or indirectly, advancing any loan to any director of the company or its holding company, or to any partner or relative of such a director. The word “indirectly” is the crux of the problem.
The Bombay High Court addressed this in Dr. Fredie Ardeshir Mehta v. Union of India [1991] 70 Comp. Cas. 210 (Bom.), while interpreting the corresponding provision under the Companies Act, 1956. The Court held that when a company lends to an intermediary knowing that the funds will reach a director, the transaction is an indirect loan to that director regardless of how many entities stand in between. This interpretation was never overruled and applies equally to Section 185(1) of the 2013 Act.
A Common Illustration
Consider this: a Holding Company lends funds to its wholly owned Subsidiary invoking the Section 185(3)(c) exception, which permits such lending. The Subsidiary then advances the same funds to Mr. X, a common director of both companies. The Holding Company has, in effect, indirectly loaned money to its own director, which is squarely prohibited under Section 185(1).
The Section 185(3) exception is being widely misused as a shield for exactly this kind of arrangement. That exception only protects the transaction if the funds are used for the subsidiary’s principal business activities. The moment they are onward lent to a director, the condition is violated and the original transaction itself becomes tainted.
Where Section 186 Adds to the Problem
Section 186 independently requires that any inter-corporate loan beyond sixty percent of paid-up share capital and free reserves, or one hundred percent of free reserves, whichever is higher, must be approved by a special resolution of shareholders. In step-loan structures, funds are routed through multiple layers and the aggregate exposure at the group level is difficult to track. As a result, companies frequently breach these thresholds without ever obtaining shareholder approval.
The consequences of breaching both sections simultaneously are significant. The company faces a fine between five lakh and twenty-five lakh rupees. Every officer in default risks imprisonment of up to six months or a fine in the same range, or both. The director who received the loan is personally liable under Section 185(4). The company’s auditor is also duty-bound to report the violation, which can affect creditworthiness and reputation.
Why This Has Gone Unnoticed
Two reasons explain the silence on this issue. First, the Companies (Amendment) Act, 2017 introduced Section 185(2), which relaxed the law by permitting loans to director-interested entities subject to a special resolution and restricted end-use. Many practitioners treated this as a general relaxation and stopped examining group structures for residual violations. The reality is that Section 185(2) applies to loans to director-interested entities, not to the absolute prohibition in Section 185(1) against loans to directors themselves, whether direct or indirect.
Second, MCA enforcement has historically focused on listed companies. However, the MCA Compliance Facilitation Scheme, 2026 under General Circular No. 01/2026 now requires all companies to file annual returns and financial statements, which increases regulatory visibility into inter-corporate lending patterns across the board.
The Solution
Audit Group-Level Lending Immediately
Every group company should map all inter-corporate loans, guarantees and securities across entities and trace the ultimate beneficiary of each transaction. The key question is whether the funds, through any chain of intermediaries, ultimately benefit a director or a director-connected person. This review should cover at least the last three financial years.
Regularise Past Defaults and Restructure Future Transactions
Where defaults are found, the company should initiate corrective action through repayment, restructuring or regularisation. Voluntary disclosure to the Registrar of Companies under the Compliance Facilitation Scheme, 2026 is advisable, as it demonstrates good faith and may reduce penalties.
For future transactions, where a genuine business need exists, the correct route is to obtain a special resolution under Section 185(2), ensure funds are used strictly for the borrower’s principal business activities, and maintain supporting documents such as board minutes, loan agreements and utilisation certificates.
Strengthen the Audit Committee’s Role
Section 177(4)(v) already requires the Audit Committee to scrutinise inter-corporate loans. This obligation needs to be taken more seriously. Companies should build a Director Interest Declaration into standard loan approval processes so that the Section 185 analysis happens before a transaction is approved, not after a problem surfaces.
The Corporate Laws (Amendment) Bill, 2026 proposes an In-House Adjudication Mechanism to handle procedural defaults through civil penalties rather than criminal prosecution. This is a positive reform, but it will benefit only those who act before the default is discovered. Those caught under the old framework may still face criminal liability.
Conclusion
Sections 185 and 186 of the Companies Act, 2013 stand for a simple proposition: company funds must serve the company, not its controllers. The step-loan trap is not a theoretical risk. It is a live and unaddressed compliance problem embedded in the structure of many Indian group companies today.
As the Corporate Laws (Amendment) Bill, 2026 progresses through Parliament, boards, company secretaries and legal advisors must use this window to review their group lending arrangements carefully. The law has always been clear. What has been missing is awareness and diligence. Addressing this gap now is both a legal obligation and a matter of fiduciary duty.
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